Avoid These Costly Investment Blunders

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Morningstar.comAvoid These Costly Investment BlundersThursday August 16, 7:00 am ET By Sue Stevens, CFA, CFP, CPA
Buying a fund or a stock is relatively easy. It's the selling part that can get complicated.
With the stock market roaring up and down (and mostly down, lately) hundreds of points in a day, you may find yourself thinking about cashing in on some of your gains. Or perhaps you're thinking about locking in a loss on a holding because you want to be able to reduce the effect of capital gains elsewhere in your portfolio.
But before you pull the trigger and sell, you'd better know where you stand with both realized and unrealized gains and losses. Realized gains and losses reflect the selling you've already done for the year to date. Unrealized gains and losses reflect how a security you still hold has changed since you bought it. For example, if a stock has appreciated but you haven't sold, you have an unrealized gain in it. If you know where you stand with realized gains and losses, you can use that information to determine if you want to sell some of your current securities with either a gain or a loss.
For example, if you find you have substantial realized gains so far this year, you may only want to focus on selling securities that you're holding at a loss. If you have loss carryforwards on your tax return (see Schedule D), you may want to net those out by selling some securities that have appreciated strongly, thereby reducing the capital gains tax you'll owe on those appreciated securities.
What Is Cost Basis?The "cost basis" is the original purchase price of an asset plus any reinvested dividends and capital gains.
If you ignore reinvested dividends and capital gains, you'll end up paying tax on those shares twice. And you don't want to pay more tax than you have to.
Want a simple solution to this dilemma? Don't have your brokerage or mutual fund company reinvest the capital gains and dividends. You can direct them to put those payments directly into your money market account. Then later you can decide just where you want that additional money to go. It's certainly simpler than hunting down all reinvested capital gains and dividend payments.
Some brokerages keep track of the cost basis for you. Look at your statement to see if it reflects "cost." Even if it doesn't, you may want to give your brokerage a call to see if they can send you that information, or you may be able to retrieve it online. Some companies have that information but don't make it available unless you specifically ask.
Calculating Cost Basis The IRS allows you to use one of four methods when calculating your mutual fund's basis. You'll need to think about this decision before you actually sell anything. Your choice will affect how you treat sales in the future.
* Average cost (single category): Most people (and brokerages) use this method. You add up all of your purchases of the security, including reinvested dividends and capital gains, and divide by the total number of shares you own. To determine whether your gains/losses are short-term or long-term, you assume the oldest shares are sold first. Once you use this method to calculate the cost basis of shares you've sold, you must continue to use this method for the rest of the shares you sell in the future.* Average cost (double category): This is similar to the above method, but first you sort your shares into two categories: those in which your gains and losses are short-term and those in which you have a long-term gain or loss. Then you add up the purchases in each category and divide by the number of shares in each category.* Specific-share identification: This method is a little trickier, but it can also save you money. You specifically tell the brokerage which shares you want to sell and use the cost basis of those specific shares. For example, you may have bought shares of XYZ company five years ago when prices were higher--let's say $15 per share. Then later you bought more shares when the price was lower--say $5 per share. If you specifically tell your brokerage firm to sell the shares that you purchased at $15 and you sell them at $16, you only have to pay tax on the $1 per share of capital gain. If you specified the shares with a $5 cost basis, you'd owe tax on $11 per share. * FIFO (first-in, first-out): If you don't specify a method for calculating your basis, the IRS will assume you're using FIFO. This method assumes that when you sell some of your shares, they are the first shares you bought. If those shares have a lower cost basis, you'll end up owing more in capital gains tax (and vice versa).
When calculating cost basis on stocks, the average cost basis may not be used.
Figuring Out How Much You OweTo find out how much income tax you'll owe, you subtract your basis from the fair market value of the security when you sell it. If you held the security longer than one year, you'll have either a long-term capital gain (if you sold it for more than your basis) or a long-term capital loss (if you sold it for less than your basis). If you held the security for less than one year, instead of long-term gains or losses, you'll have short-term gains or losses.
You can net out capital gains and losses against each other.You can then use as much as $3,000 of capital losses in any one year to offset ordinary income on your tax return. Unused losses can be carried forward indefinitely to future years.
If someone has gifted you securities, you retain their cost basis. That means the donor needs to tell you what that basis is. Then going forward you need to keep track of additional purchases and reinvested dividends and reinvested capital gains. When you eventually sell the investment and calculate your basis, you start with the donor's basis and add to it any additional purchases and reinvested amounts. For more on this topic, see IRS Publication 551 at www.irs.gov.
Why Basis Is ImportantThe higher your basis, the less you pay in taxes. It's that simple, but record-keeping for this purpose is anything but simple. Ideally, the day you buy a stock or fund, you should start a notebook or spreadsheet entry that documents your purchase. Then you would add to your records as you purchased more or reinvested dividends and capital gains.
If you're like many people, you've thrown out old statements and have no idea about reinvested amounts. There are a couple of ways to recreate these records:
* Take a look at each tax return you've filed since you had the investment. Reinvested dividends and capital gains will be on Schedules B and D. However, many brokerage firms just lump together all your dividends and capital gains for tax purposes. If that's the case, you'll just see something like "Schwab" listed, not each individual security. And for basis purposes, you need to break it out by individual security. * Contact each brokerage firm and request year-end statements for as long as you've had the investment. They should show both purchase amounts and reinvested amounts.
Going forward, basis may become even more important. In 2010, the step-up in basis at death will be modified. ("Step-up in basis" means that the person who inherits an asset doesn't also inherit the deceased individual's cost basis; instead, the new owner's basis in that asset "steps up" to its current market value.) In 2010, a general basis increase will be allowed up to $1.3 million. Spouses will be allowed an additional $3 million of stepped-up basis.
Let's look at an example: Joe dies in 2010 and leaves securities valued at $2 million to his only son, Peter. Let's say Joe's basis is $500,000. Peter will be able to step up the basis on $1.3 million of his inheritance. But the other $700,000 will retain his father's basis. (This is just like the gifting rules for basis that I touched on above.) Then Peter will need to track his additional purchases and reinvested dividends and capital gains until he sells the securities.
Accurate record-keeping is essential. Estates may take much longer to settle if basis needs to be recreated. Holding securities until death to take advantage of the step-up in basis may no longer be a viable strategy. So be forewarned: If you don't have accurate basis records, bite the bullet and find a way to build these records. If you don't, the price could be heavy: paying tax more than once on reinvested dividends and capital gains or creating problems for your heirs by delaying the settlement of your estate.
IRS Publications If you want more information on investments and taxes, the following IRS publications may help. (You'll need Adobe Acrobat to view or print out the PDF files.)
Publication 544: Sales and Other Disposition of AssetsPublication 550: Investment Income and ExpensesPublication 551: Basis of AssetsPublication 564: Mutual Fund Distributions
A version of this article appeared March 9, 2006.
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